Europe’s path of least resistance

What is the road of least resistance scenario, and thereby the most likely scenario, for the Eurozone financial crisis? To solve this conundrum, we need to map the major elements of high resistance around which the road must navigate and the areas of low-resistance towards which the road will flow. These are:

(high resistance) It is actually politically very hard for any country to leave the Euro. If, say, Greece announces it leaves the Euro then one should expect a bank-run overnight with Greece deposit holders cashing in their savings and putting it in foreign Eurozone banks. Moreover, it might easily take a year before Greece could physically re-introduce its own currency, during which time the uncertainties and capital flight accumulate: money-machines have to be changed, accounts have to be converted, export contracts have to be re-written, and a system of converting anything valued originally in Euros into the new currency has to be negotiated. Apart from being a major hassle requiring expertise many countries do not have, it would give all the other countries an immediate excuse to stop paying that country any transfers. Young ambitious Greeks should be expected to shun a defaulting Greece. It is hence quite costly in the short run to step out of the Euro, as well as virtually guaranteeing a severe deepening of the recession overnight. This is equally true for any other country in the Eurozone: leaving the Euro is a bold and courageous step, unlikely to be witnessed any time soon. The road of least resistance therefore does not include any single country leaving the Euro.

(low resistance) The political costs to defaulting within the Euro are, when one reflects on it, surprisingly low. Greece has in effect been defaulting for several years now and has been handsomely rewarded with transfers and debt-write-offs. It was certainly the road of least resistance within Greece to steer straight into default. So too will the governments of Italy and Portugal be calculating that any default on their debts is a viable scenario and preferable to major internal upheavals that could be blamed on the government of the day. For what are other countries actually going to do when governments default on their debts? Not much. There is no mechanism via which they can kick countries outside of the Eurozone or the EU, so barring a whole set of richer countries deciding to set up a new EU and abandoning the rest, the Euro countries are stuck with each other. Countries cant kick each other out, nor can they really force any sanctions within the system. If, say, Italy decides to only pay back the government bond loans to its own banks in order to prevent them from going bankrupt but defaults on any loans held by foreigners, then the other countries have no other course of action than to protest and take the hit. They might retaliate by not honouring any loans to Italian banks but, again, apart from a wholesale break-up of the EU, they actually have surprisingly little means to punish any country. This incidentally is true even under the newly proposed stability pacts: if a country simply refuses to pay any fines then there is not much the other countries can do. Hence, defaulting is a low-cost option for individual countries.

(high resistance) The political costs for the rich countries to start a new EU of their own, the so-called rump-Europe scenario, is surprisingly high. Think firstly of how the richer countries benefit from the current union: because they suffer less from civil-service-demanded wage growth, their countries are more competitive precisely because they are in a currency-union with countries that do suffer more from civil-service driven wage inflation. This guarantees them higher levels of employment and exports, a brain drain of the less well-organised countries towards them, and very low interest rates at which to borrow, all advantages that would disappear if they cut the ties. Also, cutting the union would not in fact mean that their own banks would no longer be linked to the government bonds of other countries so cutting political ties does not actually stop the financial ties. Hence the economic benefits are neither immediate in the short-run, nor obvious in the long-run. Then think of the politics by thinking of the mechanism involved in breaking away: the countries would have to formally abandon the EU, would have to negotiate their relation with the Eurozone with those remaining in the EU (!!), then set up a new treaty for a new zone and introduce a new currency or convert the Euro into a Euro-plus that would hold for their region. Each step has to go through all the parliaments involved, virtually guaranteeing years of wrangling about the shape of a new treaty. Now, this scenario is certainly imaginable, but would take years to go into effect and hence cannot be sold by any politician as the solution to anything. Hence, a break-away by the rich countries would only be assured to lead to short-term economic loss (the countries being set loose would have to default almost immediately, with all the consequences associated to that) without clear long-term gain. It is therefore not a viable scenario. What rich countries can do is to ensure their own banks and economies are less exposed to those of the high-debt countries, but that is a slow process that takes years.

(low resistance) The European Central Bank’s determination not to become a printing press is, probably, brittle. Mario Draghi, the president of the ECB just last week reiterated how countries must help themselves. At the moment hence, the ECB is sticking to the line that it is there for price stability in the Eurozone and is refusing to write blank checks to over-spending governments. It is quite openly gambling on the current crisis to force governments into tighter spending regulation, with, it might be said, some apparent success. Yet, if the going gets really tough and neither commercial banks nor governments have the cash to pay back their loans to each other and to outsiders, is the ECB really going to refuse to bail out governments and the financial sector by means of printing money? It would seem highly unlikely that the ECB would indeed keep up its refusal for massive capital injections if its back was against the wall because it really is the only institution that can do it. More probably, it would indeed take on the role of the American Fed and simply print money on a massive scale to prevent widespread bankrupcies of governments and banks.

With this contour map in mind, the road of least resistance is starting to come into view. Given the current levels of low growth in Southern Europe and the unlikelihood of growth re-emerging soon because of all the spending cuts, it is clear that there are many countries with governments and banks that cannot pay their debts. This certainly includes Greece that is already in default, but now also quite clearly includes Portugal and probably Italy too: Italy can only pay back its debts if the interest rates are kept low by someone else.

Suppose these countries default, then the levels of loans that other governments have to extend to their commercial banks goes up, pushing countries like France and Eastern European countries closer to defaults too. This further undermines growth and pushes countries like Italy and Portugal into near-certain default. As the default-cascade gathers pace, the richer countries will find they do not actually have the means to stop these defaults and a communal appeal is made to the ECB to simply bail out the lot in exchange for a greater degree of fiscal integration and budgetary discipline in the future.

Hence, the ECB really only has the option of bailing them out heavily later on or at a creeping pace now. Which is what is happening: the ECB buying up Southern European government bonds keeps the interest rates of these bonds manageable and thus hides the real risk of default. At the same time, the EU is gradually moving towards a system in which future deficits become less likely with stricter budget controls. The grand bargain – money-printing bailout in exchange of future austerity rules – has thus been agreed to and is underway. The ECB is printing enough money to prevent an open and massive default by Southern Europe, but only as long as those countries are playing ball, i.e. by agreeing to strong reforms and future austerity. It is a difficult game that is being played by the ECB but they are playing it well.

How does the bail-out fund, supported by the IMF (with the IMF in turn supported by the ECB, a one-two that helps to circumvent the sensitivities around the ECB mandate) fit into this scenario? One would have to say that the IMF\EFSF is going to be the means via which the ECB prints money rather than a means of organising loans to tie countries over: one can organise new loans as much as one likes, but if countries and banks cannot pay them back then one is in hand-out mode whether one admits this or not. The size of the hand-out needed is such that richer EU countries simply do not have the capacity to bank-roll them, whilst it would be naive in the extreme to expect other countries outside the Eurozone to foot the bill. Hence, one way or another, the bailout will never be paid back. Only central banks have the capacity to keep handing out money that is not paid back so it is there that the eventual funds will have to come from, however it is dressed up.

Summarising, the road of least resistance is for the EU and the Eurozone to remain as it is, for the ECB to slowly hand-out large sums of newly printed money to mainly Southern-European countries and the banks that have lend to them, and to have an emerging set of institutions wherein it becomes slightly harder in the future to have large government deficits. While a Tobin Tax would be a good addition to the European institution’s ability to raise taxes and Italy/Germany/France want it, it is hard to see how one can politically implement it whilst the UK is still in the EU. The city of London would be mad to allow the UK government to exit the EU because the remaining countries would immediately coordinate on somehow taxing the city of London, so the Brits too will stay right where they are: inside the EU simply blocking any move towards communal taxation.

How strong will the new fiscal institutions be that the ECB is enforcing? Well, the golden rule in Europe is that if it would require a round of referenda or new elections then it is not going to happen. So the institutions will by necessity have to be of the wishy-washy variety, not really binding anyone’s hands. Just like the Maastricht criteria were happily ignored by both Germany and France, so too should one expect any new rules to be fairly toothless. The best they might hope for is to have a system in place with large mutual investments (a kind of future fund for Europe) that itself becomes hostage to the behaviour of the governments, i.e. you forfeit your share of the future fund if you go bankrupt. However, such a future fund would need to be funded with surplus government money and that is not going to be floating around in Europe anytime soon. So the real stick-behind-the-door is going to be that a Southern European country goes bankrupt the moment they are out of favour with the ECB. That bankruptcy will not just mean they cannot pay foreign banks back their loans but, much worse, will have to default on the bills to their own citizens because their deficits are that high. As long as the Southern European countries are indebted to the degree that they would have to default on their own population (i.e. a running deficit), these countries can be forced into greater austerity and rules on future budgetary control. The moment these countries think they can default just on the foreign part of the loans is when the ability to force them into any new rules is going to disappear.

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[…] ECB’s decision to start printing more money has been expected for a while now. Back in December, I already said it was the road of least resistance given the intransigence of the rest of the European political […]

[…] ECB’s decision to start printing more money has been expected for a while now. Back in December, I already said it was the road of least resistance given the intransigence of the rest of the European political […]